Itaú BBA - CHILE - Monetary Policy Report: Tightening Cycle Edging Closer

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CHILE - Monetary Policy Report: Tightening Cycle Edging Closer

June 14, 2018

Odds that the central bank starts tightening cycle by the end of this year are rising

The central bank’s second inflation report (IPoM) for 2018 shows stable rates are set to persist for most of 2H18 before a normalization process starts at yearend. Since the March edition, downside risks to inflation have moderated, the activity recovery has consolidated while the global impulse will be somewhat smaller (due to tighter financial conditions as the Fed confirms its normalization trajectory and inferior terms-of-trade on the back of higher oil prices). Overall, the board’s baseline scenario sees rates evolving in line with the results from the June 7 trader survey: steady at 2.5% for the next three meetings (four months) with a hike in the fourth meeting (December) to 2.75%. This is broadly similar to what asset prices infer, while coming slightly ahead of both the analyst survey and our expectation of the first hike coming in 1Q19. Stable rates for the time-being are deemed appropriate given the still wide output gap and core inflation that is still set to remain below the 3% target (partly due to extensive indexation mechanisms). The central bank has been on hold since May last year (following a swift 100-bp easing cycle), with rates in a clear expansionary stance. The central bank sees the neutral rate between 4% and 4.5% and the policy rate is expected to reach such levels in 2020.

Following the strong start to the year, the investment outlook is more upbeat. A growth range of 3.25%-4.0% is now expected for 2018 (raising the floor by 25-bps from the March edition; Itaú: 3.8%). Gross fixed investment is forecasted to grow 4.5% versus 3.6% in the 1Q18 IPoM, while total consumption projection ticked up 0.1pp to 3.6%. Growth in 2H18 is expected to be milder than in the first half of the year as the temporary supply shock passes (mining favored by a low base of comparison). Meanwhile, the central bank raised concern that slower growth of the wage bill limits consumption growth ahead. No meaningful changes were made to the 2019 growth outlook (3.25%-4.25%; Itaú: 3.5%), while growth would decelerate in 2020, to a 3.0%-4.0% range. So, the growth outlook envisions the closing of the output gap as current potential growth rate is seen between 2.5% and 3.0%, while medium-term potential growth is between 3.0% and 3.5% (in line with Itaú). Furthermore, the central bank sees risks to its growth scenario tilted to the upside.

Inflation has surprised the central bank to the upside. Yearend inflation is now seen at 2.8% from 2.3% in March following higher oil prices and the weaker Chilean peso. Average inflation for this year was raised to 2.4% from 2.1%. Meanwhile, the 2019 yearend forecast is stable at the 3.0% target, but the year average was lifted to 3.0% from 2.7% previously. On the other hand, core inflation has stayed low, but the yearend forecast was still raised 0.2pp to 2.3% and still seen at 3% by the end of next year. This is partly explained by the additional weakening of the real exchange rate and a (somewhat faster) narrowing of the output gap. The real exchange rate is seen weakening to its long-term level, which implies a depreciation of around 5% from spot levels. Overall, the central bank sees balanced risks for these inflation forecasts.

The odds that the central bank will start a tightening cycle by the end of this year are rising. Strong growth and lower risks for inflation convergence to the target (also a result of the adverse environment for emerging market currencies and high oil prices), would justify an earlier beginning of the tightening cycle compared to our expectations.  Consistent with this, the statement of the recent June monetary policy decision also contained a slightly more hawkish forward guidance. Still, the inflation outlook remains sufficiently benign to allow any hiking cycle to be gradual.

Miguel Ricaurte
Vittorio Peretti

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